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Making the case for climate risk-adjusted refinancing operations

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    Here is the third in our series of regular articles on current academic research into a range of sustainable investment topics. The papers discussed were presented at the latest annual GRASFI conference.

    Compelling academic papers

    The Global Research Alliance for Sustainable Finance and Investment is a collaboration of universities committed to producing high-quality interdisciplinary research and teaching curricula on sustainable finance and investment. In this series, we highlight compelling papers presented at the latest GRASFI conference, with a comment from a ‘practitioner’ at BNP Paribas Asset Management.   

    As the sustainable investor for a changing world, BNP Paribas Asset Management sponsors GRASFI’s efforts to bring academic rigour to the challenges of sustainable finance and investment. Through its sponsorship, BNPP AM is able to access leading academic research into sustainable finance and investment, helping to inform the broader debate. Our goal is to share these reflections with clients and the industry. Visit the GRASFI Conference website.   

    The European Commission is clear that “improved measurement and modelling of the impacts of climate change on financial stability is needed” and that central banks need to do more to manage their exposure to environmental risks.  

    In the paper CAROs: Climate Risk-Adjusted Refinancing Operations, the authors [1] note that since the global financial crisis in 2007/08, central banks have increasingly used targeted refinancing operations (providing central bank money to credit institutions) to meet their overall objectives, such as improving liquidity conditions in the financial system.

    According to the Council on Economic Policies (CEP), “‘none of them, with a few exceptions in developing economies, has aligned its targeting with the objective of a transition to a low-carbon economy.”

    The authors say that central banks can use climate risk-adjusted refinancing operations (CAROs) to direct bank lending to projects with low climate risks.

    Climate risks in financial markets and banks’ lending decisions

    Several policymakers have highlighted that climate risks may not be priced properly by financial markets and financial intermediaries due to subjective beliefs about climate change and the related physical as well as transition risks.

    As the authors say: “From a central bank’s perspective, without intervention, the different beliefs of private agents lead to a resource allocation in the decentralised equilibrium that is suboptimal.”

    If the central bank believes that a sector has a greater exposure to climate risk than private agents do, it can decide to influence, for example, banks’ lending decisions.

    One option is to condition banks’ borrowing costs for central bank liquidity on the climate risk exposure of individual asset holdings. This trickles down to the real economy through higher (lower) funding costs for more (less) climate risk-exposed firms.

    The authors say that with the optimal design of its facilities, the central bank can always induce the allocation that is optimal under its beliefs about climate risk.

    CAROs – Climate risk-adjusted refinancing operations

    The paper studies a climate-oriented monetary policy where the central bank uses differentiated interest rates in its refinancing operations that depend on the climate risk exposure of an individual bank’s assets. Monetary policy operations are also analysed in an environment characterised by private and public agents having differing beliefs about climate risk.

    The paper asks three questions: 

    1. What are implications of belief differences between private agents and the government for the real economy?
    2. From a central bank perspective, what is the optimal monetary policy in the presence of such differences?
    3. How is the optimal monetary policy affected by climate risk mitigation, concerns about financial instability and climate-related targets? 

    The authors found that the central bank can ‘fully eliminate the belief-driven distortion of the loan allocation and induce the allocation which would emerge if private agents shared the government’s beliefs, and the central bank does not intervene’ by using CAROs.

    If agents attach a lower probability to the transition than the government, the optimal marginal liquidity cost factors set by the central bank are higher for the risky sector than for the riskless sector. The paper shows that the intensity of central bank intervention, as measured by the absolute difference of the marginal cost factors, increases with the belief differences between private agents and the government.

    The authors write: “A differentiated interest rate policy on reserves allows the central bank to influence the allocation of loans in the economy, through the liquidity costs for banks. For example, if the government finds more likely that the transition occurs, compared to private agents, the central bank can counteract the belief-driven effect on the allocation of loans by setting higher marginal liquidity costs for loans allocated to the more climate risk-exposed sector.”

    The authors also favour the use of climate risk mitigation technologies (CRMT), by accounting for financial stability concerns and by featuring climate-related allocation targets.

    They say: “We find that CRMT investment decreases the need for the central bank to intervene, no matter the beliefs of private agents and the government.”

    While the authors are in favour of CAROs as a means of managing climate risk in the financial system and encouraging lending to those sectors that may mitigate environmental damage, they concede that more research is needed in this area.

    The paper concludes: “Our analysis is a first attempt to formally analyse central bank refinancing operations taking climate risk into account. Similar to CAROs, the pricing of central bank reserves can be conditioned on other characteristics of bank assets.” 

    Commenting on the paper, Richard Barwell, head of macro research at BNP Paribas Asset Management, said: “The paper illustrates how central bank refinancing operations could be adjusted to account for climate risk in order to help guide the economy on the path to net zero. However, just because you can doesn’t mean that you should. It is not obvious why central banks should be imposing taxes and subsidies in the pursuit of allocative efficiency. This task typically belongs to elected politicians. Before any tools such as CAROs are implemented, there is an important debate to be had around the role of central banks in promoting the low carbon transition.” 


    [1] Florian Boeser and Chiara Colesanti Senni 


    Please note that articles may contain technical language. For this reason, they may not be suitable for readers without professional investment experience. Any views expressed here are those of the author as of the date of publication, are based on available information, and are subject to change without notice. Individual portfolio management teams may hold different views and may take different investment decisions for different clients. This document does not constitute investment advice. The value of investments and the income they generate may go down as well as up and it is possible that investors will not recover their initial outlay. Past performance is no guarantee for future returns. Investing in emerging markets, or specialised or restricted sectors is likely to be subject to a higher-than-average volatility due to a high degree of concentration, greater uncertainty because less information is available, there is less liquidity or due to greater sensitivity to changes in market conditions (social, political and economic conditions). Some emerging markets offer less security than the majority of international developed markets. For this reason, services for portfolio transactions, liquidation and conservation on behalf of funds invested in emerging markets may carry greater risk.

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